Parliament demands more accountability for credit ratings agencies

In the years leading up to the crisis, credit rating agencies were enthusiastic about giving complex financial instruments high ratings leading investors to buy them up, usually with no questions asked. Despite their high ratings these products later proved toxic and created huge losses, so now taxpayers have to prop up the financial system. Agencies are back with the vengeance, warning countries to tighten up their belts if they don't want to see their borrowing costs explode.

The Parliament's Economic and Monetary Affairs Committee will vote on German Liberal MEPs Wolf Klinz non-legislative report on credit ratings agencies on Wednesday, 16 March. The report supports measures and initiatives that would make market players (investors, banks, central banks) more engaged in risk analysis, which would reduce their over-reliance on ratings.

It also demands agencies be exposed to civil liability in cases of gross negligence. Mr Klinz told us that we should "attach liability to credit rating agencies for their ratings. The statement by agencies that ratings are mere expressions of opinion does not hold and more responsibility and accountability is needed urgently."

It also calls for the establishment of European Credit Rating Foundation. As Klinz told us: "A European credit rating agency is only advisable if it is fully independent and free from influence from public or other bodies. The idea behind an independent European Credit Rating Foundation is to foster competition in the quasi-oligopolistic industry structure where three globally active firms dominate the market."

How it works

In terms of how it would work people would put their savings (for retirement) in mutual and pension funds which command huge amounts of money ready for investment in shares, bonds and complex financial products.

Investing in a complex financial product means lending money to the seller / issuer of the product and you expect to get your money back with interest. It is therefore of paramount importance to know how safe a particular product is. This is where  credit rating agencies that issue opinions come in as investors rely on them.

The higher the rating the safer the product and lower the interest rate (i.e. people will lend you money on the cheap if they're sure you'll pay them back). The lower the rating, the higher the interest rate on a riskier product (i.e. people will lend you money, but with higher interest to compensate for risk of you going bankrupt and them not getting all their money back).

Where did it go wrong?

In terms of where Mr Klinz thinks the current system went wrong he identifies conflicts of interest. As agencies earn money by charging fees to sellers of products for rating the latter and sellers want the highest rating to be able to sell their stuff dearly. Therefore there is an incentive to give high ratings even to subprime products to attract business and earn more fees.

As Klinz says "the key problem however was that credit rating agencies both rated these assets and at the same time were rendering advice services to the clients who were paying for the rating. This conflict of interest is at the core of the problem. The new European Supervisory Authority on Securities and Markets, ESMA, is taking up its duties in supervising credit rating agencies directly this summer. "

Many see advice services as problematic because an agency can advise an investment bank how to structure a product to get the highest rating, although the product itself is thereby not made safer, it only looks like it is.

Such irresponsible but highly profitable behaviour made the crisis worse, so governments (i.e. taxpayers) had to go even deeper into debt to rescue their financial systems.

However, worried by this increase in debt the agencies are now downgrading countries and their bonds (the lower the rating, the higher interest rate and the higher debt burden), forcing the taxpayer to pay even more; governments respond with slashing spending on e.g. social services to placate "the markets"

As Mr Klinz remarks "there is also the corporate and public debt sector. The two latter did not exhibit the same faulty ratings as in the case of structured finance products. However, I agree that the repeated downgrades in particular in the case of Greece and Spain came too late and did not help calm the markets."